How Proof of Reserve Can Build Back Trust in Crypto

As part of FTX’s rapid fall, users were restricted from withdrawing their assets, and many users may never recover their investments. This series of events has placed increasing pressures on other exchanges to prove that their customer’s funds are safe. It has also sparked many significant discussions regarding the liabilities of exchanges and the need for proof of reserves.

Binance’s stress on the importance of transparency also contributes to the gaining traction for “proof of reserves”. Proof of reserves (PoR) is a form of self-regulation. With regulators eager to set standards for exchanges to protect consumers from FTX-like incidences, PoR becomes a vital component of securing users’ funds. But what is it, how does it work, and is it the answer for custodial exchanges to regain consumer trust?

What is Proof of Reserves (PoR)?

Proof of Reserves (PoR) is a way for exchanges or custodial financial platforms to provide transparency of their crypto holdings through a verifiable audit conducted by a third party with cryptographic proofs. It displays an exchange’s capacity to honor withdrawals at all times and proves that the centralized exchange has a reserve that matches user crypto deposits. PoR takes into account both liabilities, which is the current record of consumer crypto deposits, and assets, involving several exchange addresses holding a pool of crypto tokens. While this solution involves blockchain tech elements, it still relies on a third-party auditing firm to verify any off-chain assets.

However, it still begs the question: “Will Proof of Reserves calm investor fears?”

How does a Proof of Reserves work?

Centralized exchanges hold users’ deposits on a hot wallet to complete withdrawal requests from their customers. Usually, they have a cold or hardware wallet set apart to safely hold consumer deposits. Hence, when users make their deposits to an exchange, the exchange moves the assets between the hot and cold wallets. With this system, consumers are not in complete control of their assets. Instead, the custodial firms maintain the private keys to these wallets. Users holding their private keys in decentralized exchanges or non-custodial wallets can verify their reserves from their wallets without the need for a third-party auditor.

The details of the assets that a centralized company holds can be partially obtained by monitoring transaction details in the hot and cold wallets. This approach doesn’t disclose the proportion of assets that individual users own. Hence, PoR auditing carried out via a Merkle Tree approach enables a deeper understanding of the total assets that a centralized exchange holds in their reserves.

The possible approaches to proving reserves include:

  • Self-attested proof-of-reserves, or proof of assets, where the crypto platform publishes their wallet addresses with proof of associated private keys. The downside is that there is no way of validating that the assets add up to more than the liabilities.
  • Independent PoR audits from third-party auditors.
  • Self-attested proof-of-reserves and liability, which involves proving both liabilities and assets using the Merkle Tree approach verify users’ inclusion in the specific balances of the aggregate assets and liabilities. This approach, however, violates the consumer’s financial privacy by disclosing their balances or activities on the platform.
  • Independent PoR and liability audits conducted by third-party auditors.

However, none of these approaches account for off-chain liabilities like lending activities.

A Merkle Tree, also called a hash tree, involves data structuring where the stored data is easily accessible and verifiable. Each Merkle or hash has distinct data and is grouped into independent branches but connected at a common root, the Merkle hash root. The root provides a single point of verification to ensure the right information is available to each of the branches. This approach separates related data to make each data set individually accessible, without having to go through each branched data.

The Merkle root also ensures that the data in each branch is tamper-proof. Since blocks introduced to the network are hashed, the Merkle tree facilitates the storage and identification system, holding the data corresponding to their hash rather than the entire chain. Therefore, the data in the block becomes verifiable via the hash, without the need to compute the entire blocks within the chain.

In a discussion with Coinbase, Binance, Kraken, and Balaji Srinivasan, Ethereum’s co-founder Vitalik Buterin commented that a Merkle Tree was good for proving liabilities, but it was unreliable in user privacy. Buterin recommended that centralized exchanges use technologies like Zero-Knowledge Succinct Non-Interactive Argument of Knowledge (zk-SNARKs) to prove reserves instead of relying on fiat systems. This approach involves depositing user assets in a Merkle Tree and introducing the zk-SNARKs layer as proof of the true acclaimed value. The extra cryptographic layer would hash user data to improve user privacy. It also involved restricting exchanges from withdrawing user funds without their consent.

Proof of Reserves approach to regaining consumer trust

Before the collapse of FTX that revealed a trail of long-running user funds mismanagement, investors generally trusted custodial exchanges to keep their digital assets safe. The ripple effect from the collapse caused mass panic and a hard push for transparency and accountability. The implementation of PoR would:

  • Enable users to conduct due diligence on the platforms before investing — A Proof of Reserve system would make it easy for users to easily research the exchange before committing their funds. Transparency would reduce the probability of investors losing their funds due to mismanagement and improve the integrity of exchanges, especially in their financial dealings.
  • Facilitate verification of custody assets — The main goal of PoR is to allow consumers to validate that their assets are safely held in the platform. It also enables them to track modifications made to their accounts for better oversight and clarity on how their funds are handled.
  • Introduce a hands-on transaction record — PoR would allow users to monitor their personal transactions and activities while verifying that their financial activities are accurately recorded.
  • Serves as a single source of truth — Transparency in record-keeping systems will make on-chain transactions verifiable, ensuring that users can scrutinize the data for accuracy to eliminate errors or loopholes.
  • Help regain and retain consumer trust — Proof of Reserves is a way for custodial exchanges to redeem themselves by reducing the current fear in the market.

Bottom line

Proof of Reserves is a step in the right direction for any digital assets firm to regain back consumer trust by proving that the firm has sufficient liquidity and does not mismanage users’ funds. Any crypto exchange that acts as a custodian of consumer assets stands to benefit from this concept. While it exhibits some shortcomings, it can boost consumer confidence and provide assurance of their funds’ safety.

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